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One of the toughest challenges for regulators is foreseeing and managing unintended consequences. Sometimes these are side-effects that hit ancillary activities, and sometimes they are an actual backfire – government action worsens the very problem it is trying to solve. This backfire is occurring today in mortgage and consumer lending, where well-intended regulation and enforcement are undermining the goal of fair access to credit by driving providers out of the market.

Industry laments about regulatory burden are obviously old news. What’s new and alarming, now, is that lenders are not just complaining. They are giving up. They are beginning to curtail mortgage and other consumer credit due to sheer fear that they can’t figure out how to comply with the laws. I’ve been hearing this for at least a year (see my post of June 18th - Compliance Summit), but never more pointedly than at recent roundtable of thoughtful people involved in housing – lenders, advocates, government officials, attorneys, real estate brokers, academics, innovators, and providers of mortgage-related services. The emotional intensity in the room spiked as industry participants described a whole new kind of frustration and pessimism. The saddest part is that the borrowers who will be hardest hit by lender retrenchment are the vulnerable families the government wants most to help.

Invisible rules

The core challenge is that regulatory punishment has preceded regulatory clarity. To some extent this is unavoidable -- the financial crisis clearly called for both heightened enforcement and a deep rethinking of the regulatory risk standards that failed so dramatically. Given the complexity and novelty of the issues, regulators need time to figure out and codify new norms on many topics. While they do so, they are necessarily employing a high degree of subjective judgment that, in turn, is inevitably bringing ambiguity, unpredictability, and inconsistency. The “rules” today are simply not clear enough for the industry to follow -- and yet failure to follow them carries very high penalties. Whether the regulators could have done this better is an interesting question but is ultimately irrelevant to the impact on the market.

Examples of unclear, subjective standards cross wide swaths of regulatory activity, especially in lending. One area is the escalating use of “disparate impact” legal theory for enforcing the non-discrimination laws in cases where there is clearly no discriminatory intent. Regulators analyze statistics showing that a lender’s loan approval rates or pricing come out differently for different groups of customers (which occurs almost universally since applicants’ creditworthiness varies), and then require the lender to prove a business justification without explaining what factors are considered valid. Another driver is UDAAP – the ban on Unfair, Deceptive, and Abusive Acts and Practices. Intensified enforcement by both the CFPB and prudential banking supervisors has succeeded in capturing everyone’s attention, but have not been followed by practical guidance on how to meet these intrinsically subjective requirements.

Compounding the challenge is the aggressive enforcement and litigation climate, particularly in mortgages. The government is invoking powers in new ways under the False Claims Act and the Financial Institutions Reform, Recovery and Enforcement Act (FIREEA) to allege fraud and threaten tremendous penalties. Potential damages are so high that lenders feel forced to settle even before seeing legal charges that are developed fully enough to rebut. They also face shifting standards on recourse over mortgage representations and warranties and interpretations that are effectively lengthening statutes of limitations. Challenges are coming from all directions – borrowers, shareholders of all kinds, counterparties, FHA, GSE’s. Banks also have to address new capital standards for mortgage servicing. Even the central premise of mortgage pricing – that a house is reliable collateral that sharply limits risk – is now in doubt not only because home values collapsed, but also because foreclosure law and policy are in upheaval.

Temporary or forever?

The industry has assumed this post-crisis enforcement era will run its course and eventually evolve into a new normal that should work for all. Some observers see glimmers of this hope in last week’s $16.65 billion settlement of the Bank of America mortgage case – perhaps this signifies, for mortgages, that the end may be near. Maybe so, but I increasingly hear a new concern. What if all this huge unpredictable risk is permanent? It’s one thing to redress past actions. It’s another to face enormous risks for new loans being originated and serviced today under best efforts to meet today’s standards. If the risks of a business cannot be understood, managed, and priced for, some providers will invest their capital elsewhere.

Backfire

It’s an understatement to say the national mood is unsympathetic to financial industry complaints about over-regulation, and again, many of these matters do involve lender fault. Still, if regulatory activity locks creditworthy borrowers out of access to loans, the public will not ultimately benefit. Lenders are already quietly retrenching, especially, unfortunately, for the lower-income and vulnerable customer groups whose needs attract the brightest regulatory spotlight. As time goes on, more providers will fully exit consumer lines of business. This is especially true for banks, many of which already find their consumer services less profitable than other business lines. For all the criticism of banks, public policy has always sought to encourage their involvement in lending for housing and especially to lower-income communities, because depository institutions are widely seen as preferable to these consumers’ other options. The Community Reinvestment Act – for which I was present at birth -- was created precisely for this reason. It would be a painful irony for public policy to inadvertently push banks out of these markets.

Regulators and advocates often assume the financial industry is a static thing that can be molded and shaped to serve public goals. They are often right. Soon, though, they will find themselves with a dwindling set of providers to mold. One senior Clinton-era official recently said the mortgage industry is being “parboiled,” and will probably emerge as something unrecognizable to us today.

Clarity is hard

Again, the problem is not that the government is being tough. The problem is that it isn’t being clear.

Regulators sometimes rightly prefer to avoid bright-line rules because industry tends to go right up to them -- a risk-filled buffer zone helps deter practices that just barely meet the letter of the law while flouting its spirit. Conversely, industry often thinks it wants clear rules until it gets them. Those bright lines sometimes get drawn in places that businesses dislike, and clear rules also almost always become detailed and burdensome, especially as they expand over time. All this is true, but still, today’s balance between clarity and ambiguity has tilted too far. If it doesn’t get re-centered, it’s not the industry that will be hurt. It’s the consumer.

Is it on the regulators’ strategic agenda to strive toward gradually giving financial companies guidance they can reliably follow, beyond deciphering lessons embedded in legal settlements? The CFPB is writing rules on some major issues, and all the regulators periodically issue clarifying material. They also try to make their rules workable in the market. Nevertheless, they don’t often express concern about hitting a tipping point where “regulatory unpredictability” – the phrase I’m suddenly hearing everywhere – decreases consumer access to good, affordable financial services. It’s worthy of some focus.